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Subprime comeback: The good, bad and (potentially) ugly ramifications

Reports of lenders lowering standards and subprime lending making a comeback have not been exaggerated. Nearly 40% of consumer loans in the first 11 months of 2014 were to people with a credit score below 640, aka subprime borrowers, The WSJ reports, citing data from Equifax. That's the highest level since 2007.

The report dovetails nicely with the NY Fed's study yesterday showing increased delinquencies in student and auto loans, the latter of which being a hotspot for subprime lending in 2014. Notably, subprime lending has not increased in the mortgage market, where lending standards remain tight. That said, the Obama administration has recently unveiled regulations that would make it easier for Americans to buy a house with little or no money down; among other initiatives, Fannie Mae and Freddie Mac are planning to guarantee loans with down payments as little as 3%, down from 5% previously and back to pre-crisis levels.

For anyone with even a fleeting recollection of the financial crisis, an increase in subprime lending should set off red flags. To be sure, we are a long, long way from the environment that led to the crisis -- when seemingly anyone who could fog a mirror could get a loan -- but 'the longest journey begins with a single step', to paraphrase Lao-tzu.

Fed officials are apparently fans of Chinese philosophy. Fed Governor Jerome Powell gave a speech in New York yesterday which demonstrated the central bank's keen focus on lending standards and risks in the leveraged loan market, which is the corporate equivalent of subprime lending. Guidance issued in 2013 "now stands in the way of a return to pre-crisis conditions," Powell said.

Hopefully he's right, and hopefully the Fed is applying the same scrutiny to consumer loans.

For all the understandable concern about the expansion of consumer credit generally and subprime lending, specifically, it should be noted that increased "availability of credit" is generally considered positive for economic growth. That's particularly true of the U.S. economy, which remains dependent on consumer spending for the bulk of economic activity; that's why most economists were so excited by the 4.3% jump in personal consumption in the fourth-quarter and increase in consumer confidence to a seven-year high.

A desire to spur more lending, and thus consumer spending, also helps explain why the Federal Reserve has kept rates at zero since 2008 -- and seems in no hurry to raise them -- despite broad signs of economic improvement.

Three-handed Economist

As with most things in life, there are many sides to the subprime lending story. On the one hand, it's a sign of lenders becoming more willing to lend again, which will help consumer spending and thus the overall economy. On the other hand, excess lending -- particularly to subprime borrowers -- was a key ingredient to the toxic stew that led the financial crisis of 2008.

On the third hand, there's the harsh reality that consumer borrowing continues to outstrip income growth, and there seems to be very little discussion of policies aimed at weaning the U.S. economy away from debt-fueled consumer spending.